The Global Financial Industry is Over-Regulated

The recent crises have brought about a barrage of regulations on banks which have reduced their profitability so much so that a number of major banks have wind down their investment banking operations. Regulation of the financial industry has been a widely debated topic ever since the Global Financial Crisis in 2008. The increased regulations on banks, such as the imposition of the Basel III and the Volcker rule, has significantly curtailed profits of the investment banking industry.

In order for investment banking to return to the pre-crisis glorious days, it is likely that a lifting or relaxing of regulations is necessary. This begs the question – do we need more or less regulation of the financial industry moving forward?

Firstly, it is commonly argued that the increased regulations will prevent future crises. By having more rules and safeguards in place, financial institutions are prevented from engaging in excessively risky behaviour. The most prominent example would be the imposition of Basel III requirements after the Global Financial Crisis in a bid to shore up the reserves of banks, reducing their risk of collapse during recession. In addition, systemically important banks are required to draft a living will to ensure an orderly liquidation in the event of bankruptcy. This minimizes the degree of external shock to the financial markets, reducing or even averting future crises.

Secondly, having more regulations will restore confidence in the global financial system. Trust in capital markets has weakened significantly due to the Global Financial Crisis. Banks which were meant to monitor credit risk, failed in their duties due to their rapacity for profits. This was driven largely by the securitization of sub-prime mortgages which allowed them to transfer the high risks to unaware investors. As the investors were the very clients whose interests’ banks are meant to protect, there was a significant moral hazard issue. Consequently, their behaviour eroded the trust of many. Increasing regulations will reduce the number of moral hazard situations as well as increase the stability of banks and their products, thereby protecting investors and restoring confidence.

Global Financial Industry – relax some regs

However, there are numerous arguments to be made for relaxing regulations as well.

One of the most common arguments for relaxing regulations is that financial regulations impose significant costs to banks and the economy. Banks have to grapple with higher compliance costs as they navigate the heightened regulatory environment. In addition, the rules of the Basel III requires bank to hold much more reserves and caps banks leverage at a lower level. These factors result in reduced profitability for shareholders and the economy in general. But the greatest cost of regulations is actually more nebulous in nature…

The greatest strength of free markets lies in its innate ability to incentivize innovation. More often than not, the free markets are sufficiently efficient in self-regulating. Market solutions address information problems, moral hazards and other frictions reasonably well. In this regard, excessive regulation can stifle financial innovation as financial institutions are prevented from fully acting in accordance to profit incentives.

Lastly, for its main supposed benefits of preventing future crises and restoring confidence, it should be noted that there is no perfect system against the innovative of the human mind. Even with increased regulations, future crises are bound to occur in a matter of time as loopholes are exploited by ‘innovative’ minds. For example, loopholes in the Glass-Steagall Act meant that commercial banks could be involved in some investment banking activities through ownership of other companies, as long as the company was not “engaged principally” in these activities. It has been reported that were commercial banks took advantage of such loopholes, leading to the decline and eventual repeal of the Act. Therefore, having more regulations is unlikely to be effective for the purpose which they were implemented and should be relaxed.

Global Financial Industry – Behavioral finance

Having addressed both sides of the issue, I am of the view that the industry is over-regulated. In a nutshell, regulation leads to orderly market practices but hamper growth and competition. Deregulation on the other hand spurs growth and competition but give room for abuses and ultimately cause too much damage to markets. However, what is most pertinent is that history has taught us that the financial industry has always been oscillating between regulation and deregulation. The Glass-Steagall Act was implemented in 1933 due to the Great Depression in 1929, only to be repealed in 1999 by the Gramm-Leach-Bliley Act. As behavioural finance teaches us, we humans are not always rationale. There is a tendency to under- and overreact to new developments. It is what gives rise to market cycles and bubbles.

There is a spectrum between over-regulation and under-regulation which the industry oscillates between due to human irrationality and political factors. Both of these root causes remain extremely difficult to change. The most recent Global Financial Crisis is no different as the increased regulations came only retroactively after the onset of the crisis, rather than before. Political will is a major factor in this. There is naturally a lack of political will to curb optimism when there is over-optimism, as well as an over-eagerness to punish the culprits harshly after the development as a show of action. The fact that a number of major banks have to wind down their investment banking operations points to the likelihood that current regulations are excessive and overdone. The reduced profitability might not be sustainable in the long run. Sometime in the future, regulators will over-compensate in their relaxation of regulations as we saw in the Gramm-Leach-Bliley Act.